Defined contribution (DC) plans are now the global norm for retirement provision. Often these plans are voluntary and require numerous decisions to be made by plan members. The assumptions once made, that plan members would value choice and choose well, are being increasingly questioned as members appear challenged by their own unconscious behaviors, abilities, apathy and inertia.

Many plan sponsors and trustees remain bewildered as to why their members act the way they do. Their plans offer a range of choices, including investment funds, as well as flexibility in retirement, yet few members seem to choose well. While employers may argue that their employees are competent and the best in their fields, people have different backgrounds and experiences, so it makes sense that a carpenter, bank clerk or sales manager may not be able to make as informed a decision as can a financially trained and educated trustee with access to financial advice and information.

There is no doubt that members’ past experiences and personal biases affect their decision making, be it choosing products in the supermarket or choosing which type of mortgage to take out. So it follows that past actions and experiences will have an impact on other financial decisions participants make. Research generally on these issues can be applied to decisions made by DC members. In this article, we look at some of the key biases identified from the field of behavioral finance, how these may affect members’ decisions and what trustees and sponsors can do to assist members with making better decisions.

We break down these decisions into three key stages in the lifetime of a typical DC member:

1. Joining
    
2. Accumulation
    
3. Retirement

This article focuses on the joining phase, and future articles will focus on midterm to pre-retirement stages and retirement.

Joining the plan

The most important, and potentially the most difficult, decision a member must make is whether to join a pension plan, although this is typically accompanied by other decisions such as how much to contribute, which asset class(es) to select and which fund managers to choose. Too many decisions to make at one time and too much information to review are likely to prevent a member from making any decisions.

In the last few years, the US has introduced automatic enrollment to help counter this behavior, allowing employees automatically enrolled in a plan to opt out if they want. With its introduction of Personal Accounts in 2012, which will establish auto enrollment in personal accounts or an employer’s equivalent plan, the UK will be  following suit.

There are, in fact, many hurdles a member must overcome to reach a decision in terms of behavioral characteristics:

Overconfidence – People are more confident in their abilities or future prospects than experience justifies; they feel that their salaries will increase more than average in the future and so they will be able to afford to start contributing at a later date or even rely on other expected sources of income (for example, property). We believe that clearer education on the tax advantages and other “free” money available from pensions, such as the sponsor’s contribution, is needed – possibly presented as a member effectively losing an entitlement to a salary enhancement. 

Procrastination – When faced with a number of decisions to make at the same time, people tend to put them all off and ultimately do nothing. Simplifying the plan-joining process by limiting the decisions they need to make or by framing the decisions in a more logical way can help improve take-up. Auto enrollment is a very effective way of increasing membership in those jurisdictions where it is available.

Myopic loss aversion – People place a far greater value on the short-term value of cash than on possible long-term returns.. For example, when asked whether they would prefer an apple in a year or two apples in a year and a day, most people would choose the two apples. However, when asked whether they would like an apple today or two apples tomorrow, they would choose the apple today. Extrapolating from this example, in order to pay their contributions to their pension plans, employees would need to receive a larger return in the short term to compensate. Thus, promoting additional benefits of tax and employer contributions in absolute terms is one way to encourage members to join a plan. Simply reducing the initial contribution or making a plan non-contributory will also increase the take-up.

Inertia – If a member doesn’t join a plan when first offered the opportunity, he or she will be unlikely to join for some time in the future, despite any best intentions to do so later. Once employees walk out of a plan presentation, they are likely to relegate decisions about joining to lower positions than those of their everyday lives. The key, therefore, is to help them make a provisional decision at the time of the offering. Similarly, members are unlikely to change a decision they have made unless prompted through a communication or other means. They could be reminded of their original decision in the presentation after the event and told that it will be executed, unless they wish to opt out.

Choice overload – The number of investment funds and the way they are offered to members can affect whether and how they choose to invest their contributions. Too much choice has been shown to act as a disincentive for members to choose their own funds, and ultimately they opt for the default or do not join the plan at all. An initial limited range of funds (fewer than six or seven) with a more extensive layer of advanced funds has been shown to encourage choice. Simplifying the name of the fund, including removing the name of the manager, has also been shown to improve fund choice.

Optimal asset allocation – Rarely do members have the skill, knowledge and ability to identify an optimal investment strategy to maximize the return of their funds or to understand the risks involved. With their knowledge and their greater access to expertise, trustees and sponsors are in a better position to offer optimal diversified strategies for members to choose from, focusing on the key elements of investment that are most appropriate to employees’ needs.

Encouraging participation: What plan sponsors can do

Where participation is voluntary and auto enrollment is possible, using auto enrollment will encourage plan participation, particularly if the DC plan is the only one offered. The chart below summarizes some case studies on increased participation rates, demonstrating that auto enrollment increases participation rates by anywhere from 12 percent to 38 percent.  

Steps to take

• Where auto enrollment is not available, limiting the number of decisions that employees need to make to join is best. By their own admission, employees feel overwhelmed when asked to make too many decisions at once. Pre-populating the application form with the most appropriate options to meet the plan objectives and making the options specific to each member can help simplify the choices. 
   
• Make contributions affordable for the lower-paid employees to encourage joining – low contributions are better than no contributions. Members can be encouraged to sign up for automatic increases based on future salary reviews.
   
• To encourage adequate savings, set the contribution for auto enrollment at a level higher than the usual rate, as this is not likely to have a material effect on members’ opting out. One of the downsides of auto enrollment is that plan members are more likely to retain the contribution rate at the level they were enrolled at indefinitely, so including automatic-increase options is best introduced at the outset.
    
• Ensure that default investment options are consistent with the plan’s design and objectives. These should provide a reasonable chance of achieving the targeted investment return.
    
• In work environments without auto enrollment, send out regular and repeated communications to encourage employees to enroll in the plan. If there are initial meetings for enrollment, follow up with e-mails to those employees who have not yet joined. These can be customized and include examples showing what would be lost by not joining the plan. For example, communications might show typical savings or what the account balance might be in 10 years and at retirement age. Examples can also include any potential match not received. Testimonials from participating plan members are another idea for e-mail content. Employers might plan targeted e-mails to the nonparticipating group every quarter.
    
• Trustees can structure a limited range of optimal investment options, tailored to members with limited understanding of or interest in investment matters. Members can be offered opportunities to opt out and choose their own funds.
    
• Trustees should retain responsibility to monitor, hire and fire managers for these select funds to ensure that they retain greater potential for outperformance.
    
• For members who want more choice, offer an extended range of funds. “White labeling” (that is, naming funds generically, such as “Global Equities”) can be used to make replacing underlying fund managers by trustees easier and ultimately reduce legacy and inertia concerns.
    
• Employ progressive, life-stage-linked communication strategies, which encourage engagement in line with a progression through members’ working lifetimes and changing financial priorities. Trustees can teach by example, allowing members to take up the reins when they feel capable. (We will cover this stage further in the next article.)
       

The plan member perspective: Younger plan members often will feel that retirement is too far away to concern them now. When faced with a new problem, people naturally make decisions based on their own priorities, experiences and circumstances. The way individuals interpret and utilize information provided to make these decisions varies by person. Whether or not decisions are rational and appropriate for an individual depends on his or her own circumstances. Behavioral finance provides insights and evidence of consistent irregularities in decision making. 

The plan sponsor perspective: Trustees can help members achieve a good outcome both by plan structure and by efforts to influence plan member behavior through education and a clear presentation of the decisions they are required to make with the advice of experts. In addition, trustees may need to recognize that even with this help, members may not be able to make some key decisions effectively and that they, as trustees, may need to share responsibility for some decisions to maximize the benefits for both the company and its employees.

Getting started is essential to successful retirement savings. Many participants (plan members) are not in a position to make good choices. We now know a lot more about what underlies their plan decision making and what to expect. Plans need to be structured so that they work for all members.  

A special thanks to the following academics whose research into the field of Behavioral Finance, including articles and papers, has been utilized in the views presented in this article:

Shlomo Benartzi, James Choi, Gur Huberman, Sheena Iyengar, Wei Jiang, Daniel Kahneman, David Laibson, Brigitte Madrian, Andrew Metrick, Olivia Mitchell, Hersh Shefrin, Robert Shiller, Richard Thaler, Amos Tversky and Stephen Utkus